Supreme Court Considers Regulatory Preference Issue

Can the IRS issue
regulations with retroactive effect? That is the central
administrative issue in a case pending before the U.S.
Supreme Court.

In January, the Supreme Court
heard oral arguments in Home Concrete &
Supply, LLC, 599 F. Supp. 2d 678 (E.D.N.C.
2008), rev’d, 634 F.3d 249 (4th Cir. 2011), cert. granted, S. Ct.
Dkt. 11-139 (9/27/11). The immediate issue in the case
is whether the statute of limitation on assessments, a
three-year period in most instances, is extended to six
years due to a substantial omission of income caused by
an overstatement of basis. A second, and potentially
more important, issue is the amount of deference courts
are required to give to Treasury regulations.

Home Concrete involved an overstatement in basis of a
partnership interest, which in turn generated a tax
loss upon disposition of assets. The transaction
giving rise to the tax loss occurred in 1999 and was
reported on the 1999 partnership return filed in 2000.
In 2004, the IRS received information that the Home
Concrete partnership had engaged in what the IRS
considered a tax shelter. The IRS audited the
partnership under the unified audit procedures
applicable to partnerships under the Tax Equity and
Fiscal Responsibility Act of 1982, P.L. 97-248, and
issued a final partnership administrative adjustment
disallowing the tax loss.

In most
instances, the IRS has three years from the time a tax
return is filed to assess an additional tax deficiency
under Sec. 6501. Home Concrete filed its partnership tax
return in April 2000, and, under normal circumstances,
the IRS would have had until April 2003 to assess any
additional tax through the tax matters partner under the
unified audit procedures and, in turn, to the partners
of Home Concrete. In this case, however, the IRS did not
propose an assessment of tax until September 2006, more
than three years after the normal statute of limitation
on assessments had expired (but within six years of
filing because the statute was tolled nearly a year for
compliance with an IRS summons).

Under Sec.
6501(e), the IRS has six years to make a tax assessment
if the taxpayer omits from gross income an amount in
excess of 25% of the gross income stated on the return.
The IRS took the position that, because the partnership
had overstated basis in the partners’ interests, there
was a greater than 25% omission of gross income from the
partnership’s return. The IRS won in district court, but
the Fourth Circuit reversed that decision in the
taxpayers’ favor.

Several court cases
interpreting Sec. 6501(e) support the taxpayers’
position—that a substantial omission from gross income
does not include one caused by a basis overstatement.
There has been extensive litigation on the issue of
whether an understatement of income caused by an
overstatement of basis constitutes a “substantial
omission from gross income,” with most cases involving a
listed transaction under Regs. Sec. 1.6011-4. After
losing several cases in court, the IRS issued temporary
and proposed regulations to bolster its litigating
position. Issued in 2009, Temp. Regs. Sec.
301.6501(e)-1T(b) sought to clarify that the definition
of “omits from gross income” includes an overstatement
of basis. Treasury finalized the regulations in 2010
(T.D. 9511). The regulations were clearly designed to
stem the IRS’s litigation losses and to tacitly overrule
the Supreme Court’s decision in Colony Inc., 357
U.S. 28 (1958). The regulations also had a retroactive
effect—the IRS would never have been able to litigate
the Home
Concrete case absent a change in the
regulations.

One year ago, the Supreme Court
decided Mayo
Foundation for Medical Education and Research,
131 S. Ct. 704 (2011). In Mayo, the Supreme
Court addressed how much weight federal courts should
give to a federal tax regulation. The issue raises a
complex constitutional and administrative law problem.
Congress has the authority to write and enact federal
tax legislation under Article I of the Constitution.
Under Article II, the executive branch, through the
Treasury Department, enforces the laws passed by
Congress and is called upon to interpret those laws
through regulations, revenue rulings, and other
administrative announcements. The judiciary, under
Article III, determines the validity of the law and
whether the executive branch’s interpretation of a
statute is in accord with the legislation passed by
Congress.

Mayo involved a
Federal Insurance Contributions Act (FICA) tax issue,
but in its opinion, the Supreme Court also addressed the
administrative law issue concerning the application of
Treasury regulations. The Court ruled unanimously that,
if Treasury properly issues regulations to clarify an
ambiguous Code section and the regulations are a
“reasonable interpretation” of the statute, the
regulations are valid and not subject to challenge.
Under the Mayo
rationale, Treasury can issue a regulation that
effectively overrules established case law, and the
regulation will be valid so long as the regulation is a
reasonable interpretation of the statute.

An agency issuing a regulation must meet the
procedural requirements spelled out by Congress in the
Administrative Procedures Act (APA), P.L. 79-404, for
the regulation to be considered valid. Generally,
regulations are issued in notice-and-comment
format—the agency issues a proposed regulation and
solicits comments. After considering comments, an
agency may modify the proposed regulation and issue it
as a final regulation. Courts will consider the
regulation valid as long as it is within the agency’s
power to issue, is a reasonable interpretation of the
law, and does not conflict with a congressionally
approved statute.

At issue in Home Concrete is whether Temp. Regs. Sec. 301.6501(e)-1T(b) was
issued in accordance with the APA and is therefore
valid. When promulgated, the regulation was issued as
both a proposed and a temporary regulation. Comments
on the proposed regulation were requested, but the
commentators’ suggestions were not adopted, and the
final regulation ended up identical to the proposed
regulation. The IRS clearly promulgated the regulation
to overturn established case law and to stem the tide
of unfavorable court decisions. There is a question of
fairness when the IRS can suddenly change the
litigation playing field by issuing a regulation to
bolster its position in court. Under the
constitutional separation of powers, is a court
required to defer to Treasury, or can the court reach
its own conclusion?

Several interested
parties, including the American College of Tax Counsel,
have filed friend-of-the-court briefs. The College
argues in its brief that retroactive, or “fighting,”
regulations are not entitled to judicial deference, as
they operate to revive a tax controversy that otherwise
is barred under the statute of limitation in effect at
the time the tax return was filed.

Resolution of
the administrative issues in Home Concrete may
have far-reaching effects. For example, a taxpayer may
have relied on judicial or congressional authorities to
take a return position due to a lack of guidance by
Treasury. Can the taxpayer’s position suddenly be
rendered uncertain when the IRS issues contrary and
retroactive regulations?

A decision in Home Concrete is
not expected until later this year. Whatever the Supreme
Court decides will have a significant effect on how
Treasury and the IRS issue regulations and guidance to
taxpayers and whether such guidance is binding.

EditorNotes

Mindy Tyson Cozewith is a director, Washington
National Tax in Atlanta, and Sean Fox is a director,
Washington National Tax in Washington, DC, for
McGladrey & Pullen LLP.

The winner of The Tax Adviser’s 2014 Best Article Award is James M. Greenwell, CPA, MST, a senior tax specialist–partnerships with Phillips 66 in Bartlesville, Okla., for his article, “Partnership Capital Account Revaluations: An In-Depth Look at Sec. 704(c) Allocations.”

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